In 14 of the past 15 Federal Reserve rate hiking cycles (dating back to 1965), equity valuations contracted during the 12 months following the initial hike. Clearly, it hasn’t happened this time around: The Fed began hiking rates in December 2015, and yet the equity bull market is now in its ninth year, with valuations near all-time highs. Meanwhile, volatility is at an all-time low amid one of the longest economic expansions on record, at the same time that central bank accommodations are waning and geopolitical risks are rising. The market could continue to grind higher, given PIMCO’s baseline of continued global growth; however, as outlined in our recent Cyclical Outlook, "As Good as It Gets," we think it’s prudent for investors to start to focus more on relative value and less on passive broad market exposure.
Equity market gains have been far from uniform in 2017. Underlying the more than 10% year-to-date return for the S&P 500 is a marked divergence among sectors, ranging from a 25% return for tech to a 15% contraction in energy, and the growth-to-value ratio has hit a historical high. Tech stocks have contributed half of the total returns this year, with strong secular trends driving growth in sales and earnings per share (EPS) and tailwinds from favorable currency movements, price momentum and anticipation that tax reform may unleash cash offshore. (Tech’s performance has attracted many investors to the space; it’s getting crowded.) Other areas of strength include healthcare and utilities, which are largely U.S.-focused sectors that benefit from stable demand, low unemployment and a benign regulatory environment.
The wide gaps in sector performance also reflect rapid secular changes spanning the economy. For example, while consumer discretionary spending is up 10% to date this year, returns for traditional brick-and-mortar retailers are down 20%. Traditional media and certain areas of energy and even technology are also feeling the effects of disruption and disintermediation.
So what do these trends mean for investors seeking to position themselves late in this economic expansion?
Valuations are full, but the market could continue to grind higher. We don’t anticipate a U.S. recession in the short-term horizon, and history also tells us that 2017 performance is not excessive. While we see a lower probability that tax reform will be enacted by the end of 2018, faster-than-expected progress on this front could make us more bullish.
Macro factors may drive sector and style rotations. We are monitoring macro catalysts such as the slope of the yield curve, the potential for an inflation surprise (and a reversal in the U.S. dollar’s trajectory), central bank normalization and increasing geopolitical risks, all of which could spur or accelerate rotations between sectors and investment styles.
Avoid crowded trades. Many active managers’ portfolios are becoming more concentrated than they’ve been historically and are deviating further from their benchmarks. Not only passive strategies, but active strategies as well are increasingly moving into larger growth and momentum stocks. As such, we believe a late-cycle rotation to cyclical, reflationary sectors (which tend to be more value-oriented and are underowned by institutional investors) is more probable than current prices reflect. Previous cycles have shown that the breadth of stocks participating in a bull market typically expands later in the cycle, which supports the case that some sectors that have underperformed to date this year could rebound.
Focus on relative value opportunities over the next 12 months. As always, we seek to identify reasonably priced subsectors in structurally attractive businesses that offer high earnings potential, while avoiding permanent losses of capital. From a sector perspective, we are positioned for a modest reflation trade that may arise from an expected uptick in inflation (owing to post-hurricane rebuilding, wage growth and a rise in energy prices), a rebound in the U.S. dollar, the likelihood of higher interest rates and expansionary fiscal policy.
- We believe financials and energy, including select oil and gas master limited partnerships (MLPs), are potential beneficiaries of a reflation trade and are underowned by institutions, and thus could benefit from a sector or style rotation.
- The underpinnings for the healthcare sector remain favorable, in our view, and we continue to see attractive risk/reward opportunities.
- We are currently more conservative on tech, given valuation and investor positioning data suggesting that the space is highly crowded (with hedge funds 500 or more basis points overweight, by our estimates).
- We are underweight staples and telecom, which could be hurt by rising rates.
The upshot? We believe it’s not too late for investors to seek attractive relative value opportunities and reposition equity exposures in this aging cycle.